Wednesday, December 15, 2004

Turning Points in Trend

The academics claim that timing the market is almost impossible. This is probably true for individuals who do not care to watch the markets, but any astute investor/trader can pretty readily spot major turning points in the market or in individual stocks. The best way to do this is through spotting divergences with the help of technical indicators.

Divergences occur when the security's price keeps following the trend while a certain technical indicator breaks the trend and goes the opposite direction. Here is an example using the Relative Strength Index (RSI):

Click to Enlarge Posted by Hello

As you can see with our TXN example, the price kept moving from the $24/share range to the $25/share level while the RSI was decreasing in value.

This bearish divergence is telling the astute (aware) investor that momentum is slowing down in TXN and a top should be forming. You won't know the exact date, but you should be more aware.

It should be noted that divergences can go on for seemingly extremely long periods of time. In fact, depending on what time frame you are looking at, they can go on for many months and up to a year or so.

So, when do you know the turn is going to occur?

Let's use TXN as an example. We have a bearish divergence occurring. This indicates that the price is topping and should be heading south at some point in the future. I would have been short (or sold out) at the beginning of December (Hindsight is obviously 20/20). I would have known in December because TXN didn't make a higher high. The stock price did not exceed the November high. This would tell me that the stock was going to begin heading lower.

There are other criteria to look at, but this lesson is just on divergences using RSI.

Let's look at another example using Plum Creek Timber (PCL).

Click to Enlarge Posted by Hello

You can see that PCL began a bearish divergence in December of 2003. Once we see this divergence we are on the look out for a change in trend.

We didn't see a lower high in January 2004, in March or April 2004, in June or July 2004 either. In fact, we have not seen a lower high yet. So, we would not have expected a turning of the trend yet.

Of course if you are going to delve into technical analysis, you must learn about risk and how not everything is always 100%. You could be completely wrong at times. You must be prepared for that.

For instance, let's go back to the TXN example. If I was wrong, I would have purchased the stock back once it closed 3% higher than the high hit in November. If TXN closed that high, I would have been incorrect in my analysis. I have grown to accept that I am not always 100% right when it comes to trading/investing (on other matters I would have to beg to differ).

You can learn more about the Relative Strength Index here.

Best Regards,

The Soothsayer of Omaha


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